What is Return on Investment (ROI)?
Return on Investment refers to a relative gain or loss incurred on any investment. ROI is expressed as a percentage and is quite useful in making important investment decisions and comparing two or more investment avenues.
ROI is typically used by retail investors, students, business firms while making crucial financial decisions. It gives an idea about whether to take up the investment opportunity or skip it. Projected ROI is taken into consideration by companies for initiating any new project to compute how it will generate profits for the organisation. This enables managers to make optimum use of assets.
ROI is an extremely useful tool that comes in handy while investing in mutual funds. Returns from various mutual fund schemes are calculated using ROI formula and investment decisions are taken after proper analysis of different returns on investment value.
Calculating ROI
To calculate ROI, the gain (return) from an investment is divided by the cost of that investment and expressed as a percentage or a ratio.
ROI = (final value of investment – cost of investment) / cost of investment
For example, if you invest ₹20 lakh in real estate property and plan to sell that property 2 years later. Let’s assume that the final value of the property after 2 years is ₹25 lakh.
ROI = ( 25-20) / 20 = ¼
Then you make a gain of ₹5 lakh which is ¼ ( 25%) of your principal investment. Thus, return on investment is 25% for two years, i.e., 12.5% returns annually.
Return on Investment in Mutual Funds
There are two ways to invest in mutual funds. One can either make a lump sum investment or invest via Systematic Investment Plan (SIP).
Lump sum investment refers to one time investment that an investor makes in a mutual fund scheme. Returns earned on this investment can be redeemed as per the wishes of the investor. An individual who has a large corpus of money at hand and a high risk appetite should consider investing that money in mutual funds as lump sum investment.
Investors who don’t have a large sum of money can invest via Systematic Investment Plan (SIP), which involves regular investment of small amounts of money in mutual fund schemes at predefined intervals.
Return on Investment for mutual funds via SIP can be calculated using a SIP calculator. Since the returns are compounded, investors can accrue a huge corpus with small regular installments. Power of compounding ensures that you earn returns on your principal investment as well as earned returns.
For example, if one invests ₹1000 every month for the next 20 years, and the expected rate of return is 12%, a corpus of ₹ 9.89 lakh can be accumulated. This amount can be used for various purposes such as children’s higher education, their wedding, retirement fund, etc. A monthly installment of ₹1000 is light on your pocket and doesn’t pose any financial burden, and also generates a corpus which benefits in the long run.
That’s why it is advisable to start investing early and get a good return on investment in the long run.
To calculate return on investment in mutual funds, visit: Mutual Fund SIP Calculator
Limitations of ROI
Calculation of return on investment doesn’t factor in inflation. In the formula, time is not taken into consideration, which hampers the true objective of using return on investment for making financial decisions.
Also, the cost of other factors such as maintenance costs, property taxes in the above example should also be included to arrive at true ROI value. This is why, there can be different values of ROI depending on the perspective of different people.
ROI doesn’t give any idea about the amount of risk involved in an investment. For instance, an individual considers two financial instruments namely bonds and stocks for investment. It is found that stocks offer better return on investment as compared to bonds. At face value, just looking at ROI, the investor should go for stocks. Although, since the returns from investment in stocks are subjected to market fluctuations, they are a riskier investment avenue relative to bonds. Therefore, ROI cannot be the only metric while choosing the perfect savings vehicle for you.
Hence, ROI is one of the many metrics, though an important one, which is used while making investment decisions and choosing the perfect financial instrument.
Also Read: How Do You Measure Investment Returns